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5 Reasons Why Biotech's Future is Still Bright

So far this year, the biotech sector is once again outperforming the broad market. The equally-weighted SPDR S&P Biotech ETF ($XBI) is up more than the S&P 500 as of this writing. If the year closes in the same vein, it will be the fifth consecutive year of outperformance.

After any of these years of outperformance, investors could have told themselves the sector was bound to underperform… and they would have missed what came next.

Therefore the obvious question is: what has driven the rally, and what is driving it now? Is it an artifact of QE everywhere and asset inflation that could be derailed by the next big correction? Or are there secular forces at work that would make any such correction a buying opportunity?

In reality, there are both long-term and shorter-term trends supportive of biotech’s relative outperformance.

Secular Trends Supporting Biotech

• An aging population. Throughout the developed world, demographic trends are leading towards an increased weight of the “population pyramid” towards older demographic groups. Partly this is the result of reproductive trends -- women tend to have fewer children as they become wealthier and better-educated, and as support in old age becomes a dependable function of the state rather than something that will provided by one’s children and extended family. This trend is also driven by advances in medical care for acute conditions, such as infectious diseases.

However, this trend means an increasing population vulnerable to chronic health problems which the 20th century’s medical advances have only been moderately successful in treating: diseases such as cancers, respiratory diseases, autoimmune disorders, and diabetes. These are the disorders where current biotechnology advances promise dramatic improvements in treatment, and the demand for them will be robust and driven by epochal forces.

Unless there is a reversal of the whole trend of human scientific, social, and cultural development that’s been in place for the past 500 years -- and we will say very clearly that we do not believe such a reversal is in the cards -- the demand for biotech’s cutting-edge treatments will grow inexorably.

• A wealthier population. With all the near-term volatility of markets, we must not lose sight of the fact that the line of human development is wavering around a firmly upward-trending line. Humans are getting wealthier everywhere -- wealthy not merely in the sense of possessing financial assets, but in the sense of possessing access to more goods and services. Productivity growth may ebb and flow, but it is trending up thanks to technological sophistication. This means that secularly, there will be more resources available to put towards tackling the chronic diseases of civilization. Much of those resources will be directed towards biotechnology research and commercialization.

Further, there is an intersection between the two trends. The older population tends to have more financial assets than the younger. This means that broadly, they will be able to express more effective demand, and societies where this is the case will tend to produce more of the goods they want. That also will mean support for biotechnology.

• Fundamental scientific breakthroughs. U.S. President Richard Nixon declared war on cancer and signed the National Cancer Act in 1971. That was largely a failure, because the critical scientific understanding of cancer has proven to be genetics. It was more than 30 years after the War on Cancer was declared, in 2003, that the Human Genome Project reached its goal of completely sequencing a human genome. That achievement was the necessary precursor to a “War on Cancer” that could be successfully waged, and it is only in the last few years -- as gene sequencing has dropped in price by orders of magnitude -- that biotechnology could begin to exploit this scientific revolution effectively to combat cancer. Advances in data analytics are a critical component of this work. Not only do we stand at the threshold of a world where there will be an ever-growing population at risk for chronic diseases -- we also stand at the threshold of a world where biotechnology actually has scientific answers to the need for effective treatments.

We have commented in these pages many times in the past about some of these emerging technologies and their promise -- from personalized medicine and cancer immunotherapies to gene therapies that actually cure genetic disorders rather than simply treat their symptoms. However you slice it, this new field of opportunity belongs to biotechnology.

Near-term Trends Supporting Biotech

However, it isn’t simply these huge secular trends that are giving biotech a tailwind.

Mergers and acquisitions. Powerful pharmaceutical companies have learned that their old, bureaucratic organizations are not good incubators of transformative technology.It’s easier to buy growth than to create it in-house. With margins at historic highs and many companies with strong balance sheets and excellent cash flow from their current assets, they are looking for ways to deploy that cash effectively. This may mean that in the nearer-term, many small and especially many mid-sized biotechs will be acquisition targets.

Tax inversions will still happen. As long as the U.S. corporate income tax structure remains uncompetitive, politicians can wave their hands in frustration, but companies will still find ways to move their tax liabilities to better jurisdictions elsewhere. This may make small and mid-size biotech and pharma companies overseas especially attractive targets.

Investment implications: The biotech sector has enjoyed years of outperformance. We believe that there are still secular tailwinds behind it that may help that outperformance continue: an aging population more susceptible to chronic diseases that are only now getting effective treatment, as well as fundamental scientific breakthroughs in genetics and analytics. Besides these secular tailwinds, there is also near-term support from a possible intensification of mergers and acquisitions activity as big pharma companies with strong balance sheets look to deploy cash to buy growth and improve their tax structure. For investors who want to look beyond the index funds, we continue to suggest looking for small- and mid-cap biotech firms with desirable and transformative pipeline assets -- especially in areas such as genomics, gene therapy, and immunotherapy.

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